S. van Berkum Onderzoekverslag 161 H.va n Meijl A SURVEY OFTRAD ETHEORIE S April 1998 3 j^ g EX NO £> « SUI.J.ifnA MLV: Agricultural Economics Research Institute (LEI-DLO) Afdeling Algemeen Economisch Onderzoek en Statistiek ABSTRACT A SURVEYO F TRADE THEORIES Berkum, S. van and H.va n Meijl The Hague,Agricultura l Economics Research Institute (LEI-DLO),199 8 ISBN90-5242-438- 1 Onderzoekverslag 161 99p. ,fig . Thisrepor t isa surve yo f tradetheorie s andreview s international trade implica­ tionso f the newgrowt h theories.Theorie sar e reviewed byfocusin g on questions like why countriestrad e with eachother ,wha t can begaine d bytrad e and howtrad e pat­ ternsca nb eexplained .Thes equestion shav ebee naddresse db yman yeconomist ssinc e Adam Smith and David Ricardo and still there ismuc h controversy in explaining the causeso f trade. Differences between countries,fo r instance in natural factor endow­ ments and factor prices,ca n bea motiv e for trade between two countries. Countries trade in order to take advantage of these differences. Thisconcep t of trade isbase d on (thetheor y of) comparative advantage. However, other - more modern -theorie s statetha t countriesma yals otrad e becausether ear einheren t advantages inspecializa ­ tion, arisingfro m the existence of economies of scale.Som eothe r models in modern trade theories emphasize imperfect competition,produc t differentiation andtechnol ­ ogy gaps(innovation ) acrossfirm san dcountrie s as a major sourceo f explanations for international trade. Finally, the trade implications of the 'new' growth theories will alsob etake n into account becausethes etheorie sshe d light uponth e dynamic evolu­ tion of comparativeadvantage .Thi srevie wresult si na summar yo f the main character­ isticso f thetheories ,thei r way of explaining international trade, implications of trade and the influence of government intervention. Furthermore,th e empirical evidence of the theories is discussed. Tradetheories/Growt htheories/Comparativ e advantage/Policy/Economies of scale/ Product differentiation/Technology gaps/Knowledge Thecontent s of this report may bequote d or reproduced without further permission. Dueacknowledgemen t isrequested . CONTENTS Page FOREWORD 5 SUMMARY 7 1. INTRODUCTION 19 2. TRADITIONAL TRADE THEORIES 29 2.1 Classical theories 29 2.1.1 Absolute advantage (Smith) 29 2.1.2 Comparative advantage (Ricardo) 29 2.2 Neo-classical theory 34 2.2.1 Heckscher-Ohlin-Samuelson model 34 2.2.2 Specific factors model 37 2.3 Trade policy under perfect competition 38 2.4 Empirics 40 3. MODERN TRADE THEORIES 43 3.1 Economies of scale and imperfect competition 43 3.1.1 External economies of scale 44 3.1.2 Internal economies of scale and imperfect competition 45 3.1.2.1 Monopolistic competition 45 3.1.2.2 Oligopolistic competition 49 3.1.3 Trade policy and imperfect competition 50 3.1.4 Empirics of trade theories related to economies of scale and imperfect competition 54 3.2 Neo-technology trade theories 56 4. TRADE IMPLICATIONS OFTH E NEW GROWTH THEORIES 62 4.1 New Growth Theories 62 4.1.1 Knowledge assid e product: external economies of scale 62 4.1.2 Knowledge as investment: a combination of external and internal economies of scale with monopolistic competition 66 4.1.3 Empirics 70 4.2 Evolutionary Growth Theories 71 Page 5. CONCLUSIONS 75 5.1 Evaluation of empirical tests of theories explaining international trade 75 5.2 Government policy and international trade 76 REFERENCES 79 APPENDICES 89 1. Traditional Trade Theories 90 2. Modern Trade Theories 92 3. Trade implications of the growth theories 95 FOREWORD Most agricultural trade analysisfocuse s on basic agricultural commodities and rests on traditional theoretical insights of comparative advantage, assum­ ing perfect competitive markets on which goods are homogeneous and pro­ duced under atechnolog y of constant returns to scale. However, the observa­ tion of changing trade characteristics in agriculture and food products, private businessconcentratio n and active government policy suggest that international agricultural trade analysis implies investigating market structures other than the competitive mode. In order to strengthen and buildup the theoretical and empirical knowledge base inth e field of international trade in agricultural and food products, the Agricultural Economics Research Institute (LEI-DLO) launchedth e research project 'Policy and Patterns of International Trade' which isfinance d by the Institute's budget for Strategic Expertise Development (SEO programme). The objectives of this research project are to: analyse international tradetheories ,wit h the aim to answer the question: what determines international trade patterns and which role does gov­ ernment policy play in this? assess the usability of general trade theories in explaining agricultural trade; design a concept for explaining world trade patterns in agricultural com­ modities. This publication reports on the first objective of the project. Its main aim is to present an overview of the main theories that deal with international trade, asther e are the neo-classical, 'traditional' trade theories and the 'mod­ ern' trade theories. The trade implications of the 'new' growth theories are also taken into account. This review of theories - written mainly during the course of 1996 - acts as an input in the following stages of the project. The second stage, on the assessment of the general trade theories on their applica­ bility for explaining agricultural trade, has been reported in Onderzoekver- slag 162. The director. The Hague, April 1998 L.C.Zachariass e SUMMARY Thequestio nwh ycountrie strad ewit heac hothe r hasbee nanswere d in many different ways. Differences between countries, for instance in natural factor endowmentsan dtechnology ,ca nb ea motiv efo r trade betweencoun ­ tries.Countrie strad e inorde rt otake advantag eo f thesedifferences .Thi scon ­ cept of trade is based on (the theory of) comparative advantage. However, other recenttheorie sstat etha t countriesma yals otrad e becausether e arein ­ herent advantages inspecialization , arisingfro m the existence of economies of scale.Som e other models in modern trade theories emphasize imperfect competition,produc t differentiation andtechnolog y gaps(innovation ) across firmsan dcountrie sa sa majo r sourceo f international trade. Finally,th e 'new' growth theories emphasize the endogenous generation of technological changewhic h hasimportan t implicationsfo r international trade. Themai nai mo fthi sstud yi st o presenta novervie wo fth e maintheorie s that deal with international trade.Th e general structure of this overview is illustrated infigur e 1. Ina historica lsens ew eca nidentif y three major streams (depicted asth e three columns infigur e 1).First ,w e can identify the classical and neo-classicaltrad etheorie swhic hw e callth e TraditionalTrad eTheories' . Themos tprominen t modelo f thisstrea m becameth e neoclassical Heckscher- Ohlin model that dominated the field for almost eighty years. Despite their theoretical dominance, some implications were not supported by empirical evidence.Thi sinduce deconomist st o searchfo r newtrad etheories .Thes ene w theories,whic hwer e mainlydevelope d inth e lateseventie san dearl yeighties , arecollecte d inou rsecon dmajo r stream,th e 'ModernTrad eTheories' .I nth e late eighties, ideastha t were generated by these modern trade theories in­ ducedchange si nth egrowt h literature and ledt o theso-calle d 'new' growth theories, which also shed light upon the dynamic evolution of comparative advantage.Th etrad e implicationso fthes egrowt htheorie sar eals otake n into account andcapture di nou rthir d mainstream ,'Trad e Implications of Growth Theories'. Within eachmajo rstrea ma furthe r classification inschool so f thought is made based on crucial assumptions and the main mechanism of trade. Each school of thought ispresente d with agre y ellipse infigur e 1;th e arrows be­ tween two ellipses or schools indicate a strong relation between these two schools.A relation inth esens etha t it buildsforwar d on(element sof )a forme r one but changeso r brings ina crucia l (new)assumption . An important discriminating aspect iswhethe r or nottechnolog y differs betweencountrie s(th e horizontal line inth e middleo f figure 1 representsthi s distinction).Whe na schoo lo f thought assumestha t technology differs across countries it isdepicte d in the upper part of figure 1,an d when a schoolas ­ sumestha ttechnolog y isidentica l acrosscountrie s it isdepicte d inth e lower part. Because in the new growth theories within one school technology can vary acrosscountries ,w e identified two directionswithi n theseschools .Eac h direction isillustrate d asa whit e box infigur e 1. Before we discussth e schools of thought in more detail we discussth e main relation (arrows) betweenth e schools. Asman yothe rtheories ,th e trade theories find some of their roots in The Wealth of Nations' of Adam Smith. Smith showedtha t trade ispossibl ewhe n one country canproduc e acertai n good with lesslabou r than the other country andth e other country canpro ­ duceanothe r goodmor eefficiently . Ricardoshowe dtha ttrad ei seve npossibl e whenon ecountr yca nproduc eal lgood smor eefficientl ytha nth e othercoun ­ try if the relative costso f production of two goods differ between countries. This isknow n asth e principle of comparative advantage which isstil l one of the most important concepts in trade theory. The Neo-classical Heckscher- Ohlin-Samuelson(H-O-S )mode l elaboratedth etheor y of Ricardo by introduc­ ing another factor of production (capital),bu t assuming identical production techniques across countries. An implication of this change in assumptions is that factor endowments becameth e mainexplanatio n for trade.Th especific - factor modelassume stha t onefacto r isspecifi ct o the productiono f onegood ; because the income implications are different from the standard H-O-Sthi s theory istreate d separately.